Last week, State Farm agreed to pay 80 million dollars to settle suits filed by homeowners who were hit by Hurricane Katrina. Meanwhile, Congress will soon weigh legislation that could bring the biggest changes to the insurance game in decades.

Much of this litigation and legislation turns on the problem that insurance contracts are filled with incomprehensible language that fails to put consumers and regulators on notice as to what is and is not covered. For example, the industry refused coverage for Katrina, by characterizing much of the damage as “flood damage” and by relying on an arcane “anti-concurrent causation clause” that kicks in when there is even a drop of water. One commentator explains that insurance contracts “may as well be written in hieroglyphics. They are nearly impossible to decipher, [with] one incomprehensible clause after another.”[1]

Insurers learned of the storm-surge problem decades ago, and had the option of simply modifying their policies to say, “we don’t cover damage caused by hurricane storm surges.” Yet, you won't find anything so straightforward in their contracts -- most do not even mention hurricanes or storm surges in the exclusions at all.

An established legal doctrine called contra proferentum requires that courts resolve any contract ambiguities against those who drafted the contract. Commentators almost unanimously predict that “knowing that ambiguities will be interpreted in favor of the policyholder encourages carriers to use clear language.”[2] Yet, contrary to this prediction, rampant ambiguities persist.[3]

Below – I pull together some scholarly analyses that reveal the insurers’ logic for purposefully including ambiguities in their contracts.

There is a traditional two-part economic explanation for contract ambiguities: first, transaction costs make it inefficient to try to predict and draft language for every possible contingency, and/or the drafters have “bounded-rationality”, being ill-informed or failing to properly assess the likelihood of future contingencies.[4]

But not all ambiguity is accidental or economically unavoidable. A drafter may always “leave meaning deliberately obscure, intending to decide at a later date what meaning to assert.”[5] Indeed, as Michael Rappaport explains, “Insurers often can avoid using ambiguous language in their policies. If a court does find an ambiguity, the harm is only temporary because insurers can always redraft the term more clearly.”[6] [7] While insurers know that courts will interpret ambiguities as if the insurer had chosen to provide coverage, this does not imply that using an ambiguity has the same costs ex ante as providing explicit coverage. There are three primary reasons:

First, insurers know that they can always deny that the ambiguity really exists, instead claiming that “logic” and “plain reading” settles the meaning of terms.[8] Goodwin explains the bet from the insurer’s perspective:

Courts are inconsistent. They abide by the rules of contra proferentem in one decision but ignore them entirely in another. There are many reasons for the inconsistency: human error; good advocacy on the part of the insurer (or bad advocacy on the part of the policyholder); or result-oriented decisions.[9]

Even for insurers, what is or is not ambiguous seems to be in the eye of the beholder.[10] One veteran of the insurance industry writes about the manuals that insurance companies provide to guide claims adjusters:

“It is always interesting that claims manuals acknowledge ambiguities in policies, but insurance companies will not admit any ambiguities to outsiders such as insureds, claimants, attorneys, or courts.”[11]

For the insurers there is a sliver of hope that they can have it both ways -- even ambiguous language can sometimes get past the right judge.

Second, insurers know that litigation is particularly unattractive for individual policy-holders. The Delaware Supreme Court has explained the structure of this problem:

Unlike other contracts, the insured has no ability to 'cover' if the insurer refuses without justification to pay a claim. Insurance contracts are like many other contracts in that one party (the insured) renders performance first (by paying premiums) and then awaits the counter-performance in the event of a claim. Insurance is different, however, if the insurer breaches by refusing to render the counter-performance. In a typical contract, the non-breaching party can replace the performance of the breaching party by paying the then-prevailing market price for the counter-performance. With insurance this is simply not possible.[12]

When someone’s home is destroyed, he needs money urgently just to get by – he has no litigation war-chest. Goodwin explains that,

Insureds … may not have the financial resources to litigate coverage issues and may be forced to settle cheaply or not pursue their rights at all. And even those insureds with the ability to litigate their claims aggressively are not always made whole by litigation.[13]

Consumer generally lack legal sophistication and face time pressures. Moreover, the expenses of litigating a case makes it a losing proposition, even if there is a high chance of winning on the merits.[14]

So, for an insurer, the choice of ambiguity means that they will settle claims for considerably less than the full claim. The Ninth Circuit Court of Appeals explains this logic:

When coverage and liability are established . . . a game of the strong against the weak can begin. A . . . valid and legitimate claim can be settled for far less than its actual value if the need for funds by the victim is great enough and the insurance company is obstinate enough to use its knowledge of that fact to force acceptance of a lesser sum.[15]

Economists call this "opportunism"[16] and predict that is particularly likely to occur when one party has options and the other party has “forgone unique alternatives which expose that side to exploitation by the other side,” as is the case when a consumer has a catastrophic claim and only one insurance policy that could cover the claim.[17] The key is that the insurer is the only game in town. Once his house has been destroyed a consumer has nowhere to turn, except to the one company who has been collecting his premiums all these years.[18] In essence, the policy ambiguity allows the insurers to “renegotiate the terms of [the] agreement” after the insured has already performed their end of the bargain by paying annual premiums.[19]

A third reason to prefer litigating over ambiguous language is that time is money. As David Goodwin writes,

Insurance carriers normally earn much of their profits through investing premiums received from insureds. The longer the carriers hold on to premiums without paying for losses, the more money the carriers make. For many carriers, the transaction costs of holding on to their premiums as long as possible--by denying large claims and paying counsel to defend coverage actions--even when coupled with prejudgment interest will often be less than the return that the carrier will earn on the money owed the claimant, thus making delay financially desirable.[20]

So that's the three-part explanation of why insurance contracts are so convoluted. Of course, all this gaming is contrary to the very purpose that motivates consumers to buy insurance in the first place. As the Mississippi Supreme Court and many commentators agree, consumers buy insurance not just for “risk aversion” but also for “peace of mind.”[21] Indeed, several states' supreme courts have noted the contrast between the insurance industry’s advertising messages and their claims-handling procedures:

One cannot watch televised entertainment for very long without being exposed to commercials for the sale of insurance which, for example, indicate that the purchaser will be in "good hands," that he will have the assistance of a troop of mounted cavalry, that he [will have] "a piece of the rock," or that "like a good neighbor" the insurer will be there. As such advertisements reflect, the relationship between insurer and insured does not merely concern indemnity for monetary loss [risk aversion].[22]

Even some insurance executives see the problematic nature of this bait-and-switch behavior. The Deputy Chairman of Lloyd’s attributes the increase in litigation to “a lack of honour.” He writes that, “using the legal system to reduce a claim that an insurer or reinsurer knows ought to be paid is dishonourable.”[23] He further notes the principal-agent problems involved when a case is turned over to litigators who have less of an interest in pay a claim.[24]

So what can be done? Goodwin argues that given all this potential for exploitation, the rule of “contra proferentem provides a partial weapon against an insurance company's abuse of its financially superior position.”[25] Moreover, there is some potential for consumers to recover damages for insurers’ bad faith, and this may figure into the insurer’s calculation about whether to settle. On the other hand, given that contra proferentum only arises when there are two reasonable interpretations of a policy, this reasonableness will itself be an insurer’s defense to a bad faith action. [26] So, in the end, when all the dust settles, the reputational effects may be the company’s only real deterrence to this sort of gaming. [27]

The foregoing explains why companies would prefer ambiguity over explicit coverage, but why would they prefer ambiguity over simply excluding the coverage altogether? I’ll save that question for next week.

UPDATE: We don't have an automatic track-back feature here, but here's David Rossmiller response to this post over at the InsuranceCoverageBlog. I think that he and I agree on the bottom line -- that insurer's reputations are the only real deterrence to this kind of gaming. That just raises the question -- how good are consumers at comparing the honesty of these companies?

NOTES:

[1] William Shernoff, Payment Refused, NY: Richardson & Steirman, 1986 at 137. [2] Goodwin, David “Disputing Insurance Coverage Disputes” book review, 43 Stan. L. Rev. 779 at 787 (1991). [3] Ralph Nader puts the question more ominously: “Did you ever try to read those obscure paragraphs in your insurance policy? Did you understand them? Did you ever wonder why they weren’t written in clear, simple language? The chances are that you accepted the obscurity and difficult language as just the way these matters have always been. You bought you policy based on the good faith of your insurance company. Suppose the obscure language is put there to confuse you?” Ralph Nader, foreward to Shernoff supra note 2 at i. [4] B. Douglas Bernheim & Michael D. Whinston, “Incomplete Contracts and Strategic Ambiguity”, 88 Am. Econ. Rev. 902, 902 (1998). [5] Comment to Restatement (Second) of Contracts §206. [6] Michael Rappaport “The Ambiguity Rule and Insurance Law: Why Insurance Contracts Should Not Be Construed Against the Drafter” 30 Ga. L. Rev. 171 at 174 (1995). [7] Richard Posner. “The Law and Economics of Contract Interpretation” 83 Tex. L. Rev. 1581, 1583 (2005). [8] William M. Savino and Celeste M. Butera, “Insurance Coverage and the Logical Application of the Advertising Injury Endorsement”, Mealey's Lit. Reps.--Ins., Vol. 6, No. 7, Dec. 17, 1991, at 17. [9] Goodwin supra note 2 at n38. For an example of such inconsistency, compare Gyler v. Mission Ins. Co., 514 P.2d 1219, 1221 (Cal.1973) ("claims-made" policy ambiguous) with Merrill & Seeley, Inc. v. Admiral Ins. Co., 275 Cal.Rptr. 280, 283 (Ct.App.1990) ("claims-made" policy not ambiguous). [10] See Eugene R. Anderson et al “Heads We Win, Tails You Lose: Insurance Companies Shortchange Policyholders On Advertising And Personal Injury” 620 PLI/Comm 99, 130 (documenting a range of cases where insurance companies have claimed inconsistent interpretations of their policies’ terms, depending on whether they were defending a claim or trying to get another insurer to pay a claim). [11] David Frangiamore and Thomas McGreal, How Insurance Companies Settle Cases, Costa Mesa, CA: James Publishing (2004) at §1831.14. Unfortunately, the authors cite no evidence for this proposition. [12] E.I. du Pont de Nemours & Co. v. Pressman, 679 A.2d 436, 447 (Del. 1996), cited in Ellison, J. and Law, T. “Bad Faith And Punitive Damages The Policyholder's Guide to Bad Faith Insurance Coverage Litigation - Understanding The Available Recovery Tools” SK095 ALI-ABA 251 at 255. [13] Goodwin supra note 2 at 788. [14] Frangiamore and McGreal supra at §703. [15] Holmgren v. State Farm Mutual Automobile Insurance Co 976 F.2d 573 at 578 (9th Cir. 1992). [16] Richard Bell “Opportunism and Trust in the Negotiation of Commercial Contracts: Toward A New Cause of Action”, 44 Vand. L. Rev. 221, 222 (Mar. 1991). (“In a complex economy, many business transactions take place sequentially--one party performs in part or in full before the other side executes its side of the bargain. ... Having received its benefit from the bargain, the party who is to perform last may be tempted to renege on its obligations. ... The reneging party, perceiving an opportunity to increase its gain, yields to temptation and refuses to perform.”), citing at 228 Muris, T. “Opportunistic Behavior and the Law of Contracts”, 65 Minn. L. Rev. 521 (1981) (opportunism arises when one party “behaves contrary to the other party's understanding of their contract, but not necessarily contrary to the agreement's explicit terms, leading to a transfer of wealth from the other party to the performer.") [17] Bell supra at 230, quoting Richard Posner’s example of the phenomenon: “If A contracts to build a highly idiosyncratic gazebo for B, payment due on completion, and when A completes the gazebo B refuses to pay, A may be in a bind--since the resale value of the gazebo may be much less than A's cost-- except for his right to sue B for the price. Even then, a right to sue for breach of contract, being costly to enforce, is not a completely adequate remedy. B might therefore go to A and say, ‘If you don't reduce your price I'll refuse to pay and put you to the expense of suit’; and A might knuckle under.” Wisconsin Knife Works v. National Metal Crafters, 781 F.2d 1280, 1285 (7th Cir. 1986) (Posner, J.). [18] Goetz & Scott, “The Mitigation Principle: Toward a General Theory of Contractual Obligation”, 69 Va. L. Rev. 967, at 972 (1983) (asserting that "where a developed market for substitute performance exists, the potential for opportunism is negligible"), and Muris supra at 523-24 (finding that if another performing party "were available post contract, . . . credibly no incentive for opportunism would exist"). [19] Posner writes that “the most important thing which [the law of contracts] does is to facilitate exchanges that are not simultaneous by preventing either party from taking advantage of the vulnerabilities to which sequential performance may give rise.” Wisconsin Knife Works 781 F.2d 1285. [20] Goodwin supra note 1 at 787-788. See also Frangiamore & McGreal supra at §1510B (Most insurers do not make a profit on their underwriting, but rather make money on their investments of premiums held until claims are paid.) [21] Andrew Jackson Life Ins. Co. v. Williams 566 So.2d 1172, *1174 -1175 (Miss.,1990)(upholding $200,000 in punitive damages for bad faith on a $28,000 claim.) See also Hayseeds, Inc. v. State Farm Fire & Cas., 352 S.E.2d 73, 79 (W. Va. 1986) (policyholders buy insurance --"not a lot of vexatious, time consuming, expensive litigation with [the insurance company].") See also John C. McCarthy Recovery of Damages for Bad Faith, 5th ed, Kentfield, CA: Lawpress at 9 (1990) (insurance is supposed to be peace-of-mind); Tartaglio, “The Expectation of Peace of Mind: A Basis for Recovery of Damages for Mental Suffering Resulting From the Breach of First Party Insurance Contracts,” 56 S.CAL.L.REV. 1345, (1983)(same). [22] Farris v. United States Fidelity & Guar. Co., 284 Or. 453, 479 n. 4, 587 P.2d 1015, 1028 n. 4 (1978), cited in Andrew Jackson Life Insurance 566 So.2d 1172 at n5. [23] I.R. Hiscox (Deputy Chairman of Lloyd’s), “Why So Much Insurance Litigation?” 90 British Insurance Law Association Journal 1-2 (1996). [24] Id. [25] Goodwin supra note 1 at 788 “First of all, because the rules of policy interpretation are commonly recognized and understood, and because policy interpretation is a question of law, policyholders--or at least those represented by creative and articulate counsel--often can establish coverage through motion practice and avoid the expense of protracted discovery and trial. Without contra proferentem, the inherent difficulty in establishing the mutual intent of both the insured and insurer would often preclude summary judgment on questions of contract interpretation.” [26] To establish a bad-faith action, “the insured generally must establish (1) the unreasonableness of the insurer's conduct and (2) that the insurer knew or should have known that it was being unreasonable. … It is not bad faith for an insurer to deny a claim based on a fairly debatable policy interpretation even if that interpretation is later rejected by the courts.” Richmond supra at 109. [27] “The speed with which Lloyd’s paid on the Californian earthquake of 1906, when other insurers were dragging their feet through the dust and small print, did much for the prosperity of Lloyd’s in the subsequent years. …Moreover there is some evidence that Lloyd’s is currently reaping the rewards of relatively rapid payment of claims arising from the terrorist attacks in New York in September 2001.” Clarke supra at 25.